Managerial economics 3rd by froeb ch22

11

Chapter 22:
Getting Divisions to
Work in the Firm’s
Best Interest

1
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Summary of main points
• Companies are “principals” who try to align the
incentives of divisions (“agents”) with the goals of
the parent company.
• Transfer pricing is a big source of conflict between
divisions because they transfer profit from one
division to another; they can also result in too few
goods being transferred. Transfer prices should be
set equal to the opportunity cost of the transferred
asset.
• A profit center on top of another profit center can
result in too few goods being sold; one common
way of addressing this problem is to change one of
the profit centers into a cost center. This eliminates
the incentive conflict (about price) between the
divisions.
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Summary of main points

(cont.)
• Companies with functional divisions share functional
expertise within a division and can more easily evaluate and
reward division employees. However, change is costly, and
senior management must coordinate the activities of the
various divisions to ensure they work towards a common
goal.
• Process teams are built around a multi-function task and are
evaluated based on the success of the task.
• When divisions are rewarded for reaching a budget
threshold, they have an incentive to lie to make the
threshold as low as possible, to make the threshold easier to
reach. In addition, they will pull sales into the present, and
push costs into the future, to make sure they reach the
threshold. A simple linear compensation scheme eliminate
this incentive conflict.
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Introductory anecdote:
Acme
• The by-product of producing Acme paper is “black
liquor soap” that is converted into “crude tall oil”
used in resin manufacturing.

• The Paper division at Acme sold it’s soap to the Resin

company at a transfer price set by senior management.

• But both divisions fought over the transfer price.

• The Resin division wanted a low transfer price
• The Paper division wanted a high price
• The corporate parent company “gave” the Resin
department a very low transfer prices. As a result,
the Paper division began burning the soap as a fuel
instead of selling it to Resin.

• The soap’s value as a fuel was below its value as an
input into resin manufacturing.

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Incentive Conflicts between
Divisions
• In a multi-divisional company, transactions between
divisions can create incentive conflicts.
• In these transactions the company is the principal and
divisions are the agents.
• To understand the source of conflicts that arise between
divisions, personify the divisions and consider each to be a
rational actor. Then ask the same three questions,

1. Which division is making the bad
decision?
2. Does the division have enough info. to
make a good decision?
3. Does it have the incentive to do so?

• Without proper control, these conflicts can deter profitable
transactions from occurring.
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Incentive conflicts (cont.)
• Again the answers suggest three possible
solutions

• Change the division that does the decision making,
• Change the flow of information, or
• Change a division’s evaluation and compensation
schemes

• Often, parent companies organize so that each
division is an autonomous, and separate profit
center.
• Definition: A profit center is a division that is
evaluated based on the profit it earns.
• The benefit of a profit center is that they are easy
to evaluate (and manage); the cost is that they
are concerned only with their own division profit.
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Analyzing Black Liquor Soap
Problem
•

Who is making the bad decision?

The Paper Division made the bad decision to
burn the soap for fuel instead of transferring it
to the Resins Division.

•

Did they have enough information to make a
good decision?
The Paper Division had enough information to
know that the soap’s value as a fuel was below
its value as an input to resin manufacturing.

•

And the incentive to do so?
The Paper Division was rewarded for increasing
its own profit, not that of the Resin Division.

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Transfer Pricing
• One common belief is that transfer pricing just shifts
profits between divisions & doesn’t affect firm profits.

• THIS IS A MYTH.
• Sometimes they move assets to lower valued uses, i.e.
the “black liquor soap” incident.

• Transfer pricing is always a problem between two

profit centers because they “fight” over the transfer
price.

• You can get rid of the conflict by turning one division
into a cost center.
• A cost center is rewarded for reducing the cost of
producing a specified output. (but remember, cost
centers can come with problems of their own.)

• Discussion: Are your transfer prices set equal to the
opportunity cost of the product? If not, why not?
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Paper Company Anecdote
• A company can transfer paper from its upstream
Paper division to its downstream Cardboard Box
division.
• The company set a transfer price to guarantee a
contribution margin of 25% to the Paper division.

• So, if the Paper MC is $100, the transfer price
would be $125

• The Box Division considers the transfer price to
be its MC, and then marks up the cost again.

• The Box division makes all sales where MR > MC,
but now the MC is overstated (because of the
included contribution margin of the Paper

division).

• Discussion: Solution?
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Paper company anecdote
(cont.)
• The analysis makes clear that the conflict arises
because two profit centers are each trying to
extract profit from a single product.
• This creates a “double markup” problem.
• One way to solve the problem is to make the
Paper division a cost center.
• Cost centers are not evaluated based on the
profit they earn, and so don’t care about the
transfer price.
• Once the Paper division began transferring at MC
the Box division began winning more jobs from
its rivals.
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Organizational options: Uform
• Functional (U-form): A functionally organized firm is
one in which various divisions perform separate tasks,
such as production and sales.
• Example of functional organization are Henry Ford’s
automobile assembly line, or Adam Smith’s pin factory.
• Advantages:

•
•
•

Workers develop high functional expertise.
Information can be shared easily within a division.
It’s easier to tie pay to performance because performance
is easily measured.

• Disadvantages:
•

Each division must coordinate with each other, a burden
that falls on management; and change is costly.

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Banking Coordination
Problem
• Banks have many different divisions, all of which
must work together for the bank to create profits.
• The Loan Origination Division (think of them as
“mortgage brokers”) identifies potential
borrowers, lends money to them, and then hands
them over to
• The Loan Servicing Division, which collects
interest on the loan and makes sure that
borrowers repay the loans when they come due.
• For the bank in question, there was an unusually

high number of defaulted loans.
• What caused this to occur, and how can it be
fixed?
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Banking problem (cont.)
• Three questions:

• Who is making the bad decision?
The Loan Origination Division was making risky
loans.
• Did the Division have enough information to make
a good decision?
The Division could have easily verified the credit
status of the borrowers.
• And the incentive to do so?
Like many sales organizations, the Loan
Origination Division (“mortgage brokers”) were
evaluated based on the amount of money they
were able to lend, regardless of the credit
worthiness of borrowers.
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Organizational options: Mform
• M-Form: An M-form firm is one whose divisions
perform all the tasks necessary to serve
customers of a particular product or in a particular
region.

• Advantages:

• Divisions can respond more easily to change.
• Easier to establish customer relationships because
one person can serve each customer’s needs

• Disadvantages:

• Individual workers develop less functional expertise.
• Example: re-organize a bank into “home” and
“business” loans, where both divisions originate and
service loans. This reduces incentive to make bad
loans.
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Corporate Budgeting: Paying
People to Lie

• A toy company’s Marketing Division creates sale
projections for each season. The Manufacturing
Division uses the forecast to plan production.

• Problem: There was excess inventory at the individual
business units within the toy company.

• HINT: each business unit is rewarded with a big bonus if
it meets budget.

• This system created incentives for business units to

set low budgets.

• The CEO knew this and “stretched” each budget goal,
even though he lacked specific information about
business unit.
• When the goals were set too high, the inventory was not
sold and accumulated; if too low, stock-outs occurred.
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Corporate Budgeting: Paying
People to Lie (cont.)
• Once budget goals were reached, there was no
incentive to exceed them. (“shirking”)
• Also, there are incentives to “game” the system

• Accelerate sales or delay costs if just short of
target
• Delay sales or accelerate costs if target already
met to make next year’s goals easier to reach
• Accelerating or delaying sales can be costly, e.g.,
discounts offered to customers to delay or
accelerate demand.

• Discussion: How should it be fixed?
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Corporate Budgeting: Typical
Problem

• This threshold compensation scheme creates incentives to
lie
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Corporate Budgeting:
solution

• Adopting a linear compensation scheme solves problem
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Alternate Intro Anecdote
• Company X, one of the world’s largest suppliers
of supplies for printers, copiers, and fax
machines, included two separate divisions.

• Toner Division produced toner, which it sold to
the Cartridge Division and to the external
market.
• The Cartridge Division integrated the toner into
cartridges sold to original equipment
manufacturers and consumers.
• Company management allowed the two divisions
to negotiate the transfer price of toner and
evaluated each division on its profitability.
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Alternate Intro Anecdote
(cont.)
• After negotiations were unsuccessful, both divisions elected
not to transact.

• Toner Division continued to sell to the external market at
its customary price
• Cartridge Division elected to buy toner from an external
supplier.

• The Cartridge Division ended up buying its toner from the
exact same supplier to whom the Toner Division was selling.

• Rather than paying one markup to the Toner Division, the

Cartridge Division ended up paying that markup plus an
additional margin to the external supplier
• Price was 38 percent higher cost than originally proposed
in negotiations
• External supplier’s shipment arrived at Company X’s
docks with the products still emblazoned with Company
X’s logo. CEO noticed this.
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